Body Sample...

12 PV of C1 = $400 at 7% 400 PV = = 374 1 + .07

20

Rate of Return Rule
w Accept investments that offer rates of return in excess of their opportunity cost of capital.
Example In the project listed below, the foregone investment opportunity is 12%. Should we do the project?
profit 400,000 ? 350,000 Return = = = .14 or 14% investment 350,000

21

Net Present Value Rule
w Accept investments that have positive net present value.
Example Suppose we can invest $50 today and receive $60 in one year. Should we accept the project given a 10% expected return?

60 NPV = -50 + = $4.55 1.10

22

Opportunity Cost of Capital
Example You may invest $100,000 today. Depending on the state of the economy, you may get one of three possible cash payoffs:

Economy Payoff

Slump

Normal

Boom

$80,000 110,000 140,000

80,000 + 100,000 + 140,000 Expected payoff = C1 = = $110,000 3

23

Opportunity Cost of Capital
Example - continued The stock is trading for $95.65. Depending on the state of the economy, the value of the stock at the end of the year is one of three possibilities:

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